IL&FS, DHFL shocks may be temporary triggers, but the bad news for Indian financial markets do not end there
Its a mistake to assume that ongoing market turmoil is only on account of DHFL, IL&FS issue
The joint entry of the central government, regulators and the country’s top bank to the scene to calm the choppy markets post the IL&FS scare itself is a proof that there is more that meets the eye and it is not just rumour-mongering.
Look at the series of events that unfolded after the IL&FS defaults and the speculated liquidity crunch at DHFL that triggered a bloodbath in the equity markets on Friday resulting in a 1000 points intra-day fall.
Had it been a development concerning only these two companies with no deeper implications to the broader market, the regulators and the Union government would not have stepped in. But, that’s not really what happened.
Late last week, State Bank of India (SBI) chairman Rajnish Kumar issued a statement saying that the SBI will continue to support the non banking financial company (NBFC) space and has necessary headroom to do that. The Reserve Bank of India (RBI) and stock market regulator - Securities Exchange Board of India (Sebi) issued a joint statement to iterate that both institutions are prepared to intervene should the financial markets volatility warrant such a situation.
Earlier this morning (Monday), Union finance minister Arun Jaitley too issued a statement saying the government is looking at the shocks to the NBFC space and is willing to do everything to ensure adequate liquidity for NBFCs and mutual funds. These responses do not look like usual statements and have the design of a coordinated plan to calm the markets.
What really happened with IL&FS?
IL&FS has been funding long-term infrastructure projects and is a reputed name in the sector. Being an NBFC, it sources money for long-term funding by issuing bonds and short-term commercial papers besides borrowing from commercial banks. But throughout the process, companies like IL&FS fight what is called as the asset-liability mismatch that occurs when their fund repayments are of shorter tenure than the returns from their borrowers. These bonds are typically rolled over and when this process breaks, it triggers a panic.
In the case of IL&FS which has a total liability of less than Rs one lakh crore, it reportedly defaulted on some loans including to Small Industries Development Bank of India (Sidbi). The firm missed on payments on three commercial papers which triggered further panic.
IL&FS' exposure to India’s debt and bank loan markets aren’t huge. According to Moody’s Investor Services, the firm's outstanding debentures and commercial paper accounted for one percent and two percent respectively, of India’s domestic corporate debt markets as of 31 March while its bank loans made up about 0.5 percent to 0.7 percent of banking system loans, Moody’s said.
But investors feared this would have a contagion effect. However, this wasn’t the only issue that spooked the investors. Liquidity concerns at another NBFC - Dewan Housing Finance Limtied (DHFL), came to the fore when DSP Mutual Fund sold Rs 300 crore of DHFL papers at 11 percent in the secondary market, way higher than the traded rates raising fears that borrowing costs may be shooting through the roof. The stock markets collapsed as large investors dumped these shares along with other NBFC stocks. With DHFL clarifying on its liquidity position and a rescue team being formed to bail out IL&FS led by SBI, if need be, the NBFC shock may not last for a longer duration. But, the concerns aren’t over on these issues.
Rupee scare and macro-fundamentals
IL&FS and DHFL may be the immediate triggers for panic sell-off but there’s more than meets the eye. Concerns about rising costs of borrowing are clearly dominating the investors’ psyche. There is a range of reasons at play. These include global markets turning volatile, crude staying high, US economy picking up and pushing interest rates higher and, certain weak domestic economic fundamentals such as a nose-diving currency, widening current account deficits and a big mess in the banking sector. That apart, a senior trader told this writer that markets may be on a tipping point and after a big rally, large investors may be finally looking at high valuations with caution.
Although the sentiments are battered primarily by the IL&FS-triggered liquidity shocks, there is a bigger concern that is emerging on the currency front. Despite the government’s bail-out package and government bureaucrats ‘talking up’ Rupee, the currency has not recovered from the 72-72.50 levels against the US dollar. Whatever the government has done may not be enough. “Although these measures provide credit positive support to India's external account, they are unlikely to reverse the currency's depreciation,” Moody’s said in a note on Monday.
Elaborating on its warning, the rating agency said the Indian government estimates that the measures will increase capital inflows by $8-$10 billion, or 0.3 percent-0.4 percent of GDP, in the fiscal year ending 31 March 2019. As the exhibit shows, India’s basic balance (current account plus net foreign direct investment) averaged a deficit of about 0.7 percent of GDP in the first two quarters of calendar 2018. Thus, even if the capital account measures have an immediate impact on flows, they will only partially cover India’s remaining financing requirement and alleviate only some of the depreciation pressure on the rupee, it said.
Besides a falling rupee, the ill-health of the banking sector is another major worry for investors. At this point, at least close to a dozen state-run banks are under the prompt corrective action (PAC) plan of the RBI meaning that these lenders can only operate with lending restrictions, thanks to their high bad loans and governance issues. Most of the state-run banks are neck deep in an NPA-mess.
How can a banking system which is facing such serious crisis be able to engage in major lending activities should the financial system be seized in prolonged liquidity crisis--that too only if the government generously recapitalises banks. But will it? Unlikely, since the exchequer isn’t in a very good shape.
To sum up, the banking system (70 percent of which is dominated by state-run banks) is in no shape to offer big financial support, with the only exception being the SBI and a few private sector biggies. The short point here is that at a time when the cost of borrowing is set to go up, banks are constrained with non-performing assets (NPAs) and as there are cracks in the economic fundamentals, investor concerns are unlikely to stop with one IL&FS and DHFL. There is more than meets the eye.
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